Comparing Intrinsic Value to Market Price: Buy or Sell?

Ravi had come a long way in his investment journey. Armed with an understanding of various valuation metrics, he now faced the big question: should he buy, hold, or sell? To answer this, he needed to grasp the relationship between a stock’s intrinsic value and its market price. Let’s follow Ravi as he explores this crucial concept.

Understanding Intrinsic Value

Intrinsic value is the true worth of a company based on its financials—such as cash flows, growth potential, and risks—rather than its current market price, which can fluctuate with investor sentiment. By comparing intrinsic value to the market price, investors can determine if a stock is undervalued, overvalued, or fairly valued.

Revisiting StellarTech Ltd.

Ravi had already gathered key metrics for StellarTech Ltd. but needed to decide if it was worth buying. If the market price fell below the intrinsic value, it could signal a buying opportunity. Conversely, a market price higher than the intrinsic value might indicate overvaluation.

Step 1: Estimating Intrinsic Value

To estimate StellarTech’s intrinsic value, Ravi used two popular methods: the Discounted Cash Flow (DCF) method and the Earnings Multiple Valuation.

A. Discounted Cash Flow (DCF) Method
This method calculates the present value of future cash flows based on projections and a discount rate.

• Forecasting Future Cash Flows: Ravi estimated StellarTech’s free cash flow would grow by 10% annually for five years, then stabilise at 4%.
• Discount Rate: Using the Weighted Average Cost of Capital (WACC) as the discount rate, Ravi arrived at 8%, reflecting the expected return given StellarTech’s risk profile.
• Calculating Present Value: The DCF calculation gave an intrinsic value of ₹12,450 per share.

B. Earnings Multiple Valuation
This approach uses the P/E ratio of similar companies and expected earnings to estimate intrinsic value.

• Average P/E Ratio: For the AI industry, the average P/E was 25.
• Expected Earnings: With projected earnings of ₹498 per share, Ravi calculated:

Intrinsic Value = 25 × 498 = ₹12,450 per share
Both methods produced an intrinsic value of ₹12,450 per share.

Step 2: Comparing Intrinsic Value to Market Price

Ravi noted that StellarTech’s current market price was ₹14,940 per share—20% higher than the intrinsic value, suggesting an overvaluation.

• Intrinsic Value: ₹12,450 per share per share
• Market Price: ₹14,940 per share per share

Step 3: Evaluating Market Sentiment and Other Factors

Ravi understood that comparing intrinsic value with market price was just part of the puzzle. He examined additional factors to see if they justified the higher market price.

• Growth Prospects: StellarTech’s plans to launch new AI products could lead to higher revenues, which might explain the premium.
• Industry Trends: Rapid AI industry growth meant investors were willing to pay more for innovative companies, potentially justifying the elevated price.
• Risk Considerations: However, if growth didn’t meet expectations, the overvaluation could lead to a market correction.

Step 4: Making the Decision - Buy, Hold, or Sell?

Ravi weighed three possible options:

• Buy: If he believed StellarTech would exceed growth expectations, buying could be reasonable, though he’d pay a premium.
• Hold: If he already owned shares, holding might be wise if he trusted the company’s growth would justify the price in time.
• Wait and Watch: Given the overvaluation, Ravi chose to wait. He set a target price between ₹11,620–₹12,450 per share, where he would consider buying if the market aligned with intrinsic value.

Ravi realised that patience was essential for value investing. He didn’t want to expose himself to unnecessary risk by purchasing an overvalued stock. StellarTech would stay on his watchlist until a better buying opportunity arose.

Conclusion

Ravi’s journey with StellarTech taught him that calculating intrinsic value is crucial, but comparing it with the market price and understanding the bigger picture are equally vital for sound investment decisions.

In the next chapter, we’ll explore how to use a stock screener to identify potential value stocks, combining knowledge of intrinsic value and market prices to help you filter stocks that match your investment criteria.